The Political Economy of LTRO

Executive Summary

This is not a liquidity trap; in the political context it’s a confidence vacuum!

As monetary economists we have observed crowding out in sub-markets around the world. But whether or not it exists in the global capital market system of today has not been finally empirically proven as yet. Not until today, is my view.

Some now argue that the ECB is actually telling us that we have regime-shift in the transmission mechanism; we have now a new transmission mechanism to which all the research of the recent past does not apply. There are no new studies of this new transmission mechanism, not yet but there will be soon.

It’s simple, the authorities pump money in, capital markets go in one direction but the real economy goes in the opposite one; we are crowded out. This is my new thesis: LTRO (longer-term refinancing operations; all forms of monetary stimulus) are just propping up the equity market and all securities markets, not necessarily directly via banks’ prop-desk trading but more crucially via prime-brokerage lending to hedge funds that’s the [new] transmission mechanism. But if the new transmission mechanism is effectively LTRO-predicated, what happens when LTRO (or QE, in the UK) stops?

My model is slightly more complex; that is the cheap money pump primes the prime brokerage function which on lends short term to the hedge funds who then effectively engage in round tripping at arm’s length, it is a win/win for the capital market system it inflates the equity markets and supports yields in risky government securities.

In summary this monetary inflation has all sorts of perverse effects in all sorts of (actually) indeterminate securities markets. The new normal, the new transmission mechanism is about the state pump priming capital back to the private sector via the securities markets complex, it’s a very strange zeitgeist “never been tried before.” This LTRO howitzer is massive, its really weird and its regime shifting of the modern transmission mechanism, why would you not expect to see some wild and wonderful consequences and in pretty short order in the tail of your distribution, surely that would in reality be only simply rationally expectational? LTRO and all QE variants are like vitamins; they pump up a bubble and then flush out the other side, but they so confuse the risk appraisal heuristic with political uncertainty and underlying regime shifts that they trap the real capital markets and private sector into a vacuum of political uncertainty.